Finally, you have a job, a reliable stream of income and you’re taking the money-savvy step of planning your retirement savings. Look over this guide to get yourself started on building that nest egg.
Don’t Wait, Start Now
After years of living on part-time pay and Grandma’s birthday money, you’ve finally found your first source of steady income. The newfound ability to spend can easily overshadow the importance of savings, especially retirement savings.
But, the willpower to fight against this urge will yield great rewards because the earlier you start saving, the faster your money will grow. You can thank the mathematical phenomenon of compounding, which exhibits the exponential growth of money.
Let’s say you plan to retire at age 65 and managed to scrape together $25,000 by the age of 25. If you don’t touch that money and it grows an average 6 percent annually, you’ll have $274,000 when you retire. If you started with $25,000 at age 30, at the same rate of growth, you’d have $203,000 when you stop working. Have $25,000 at age 35? Retire with just $150,000.
Tip: Use our savings calculator to play around with different savings scenarios.
So you can see that time is a major advantage when it comes to saving. Those who start saving later will end up with significantly less when they retire. In fact, many seniors cannot retire comfortably and continue to work because they didn’t save enough in their younger years.
But, there’s another compelling reason to begin building retirement savings immediately: tax advantages.
When you contribute to a retirement account, such as an individual retirement account (IRA) or a 401(k) plan, you gain tax advantages that are not available with a regular savings account or brokerage account. Since the IRS places a limit on how much you can contribute to certain retirement accounts per year, you’ll lose these tax advantages if don’t contribute for any particular year.
Open a Roth IRA
An individual retirement account (IRA) is simply a basket that can hold cash, certificates of deposit (CDs), stocks, bonds, mutual funds and more. The difference between an IRA and a savings account or brokerage trading account is the tax-advantaged component.
The two most common types of individual retirement accounts (IRAs) is the traditional IRA and the Roth IRA. If you’re just kicking off your career, the Roth IRA is likely the most appropriate choice for you.
With a traditional IRA
You can deduct your contribution for the tax year that the contribution was made. When you take the money out at retirement (called a distribution), you get hit with taxes.
With a Roth IRA
Your contributions are made with post-tax dollars. But, when you withdraw from your Roth IRA at retirement, you don’t have to pay any taxes.
Essentially, your choice of IRA is based on how you expect your tax rate to change in the future.
Those with a traditional IRA can use the tax deduction to lower their tax burden now, and hope to fall into to a lower tax bracket in the future, which will subject their distributions to a lower tax rate. Those with a Roth IRA will not enjoy a tax deduction now but when their income starts to rise, so will their tax rate, which won’t affect withdrawals because distributions are tax-free.
As a young worker, you can expect your income to increase as your career progresses — so it makes sense to go with a Roth IRA as opposed to a traditional IRA.
However, if you happen to start your career with high income, you may consider a traditional IRA instead. Also, you can have a traditional IRA and a Roth IRA, but your combined contributions cannot exceed the annual maximum. For example, if the contribution limit is $5,000 for the year, you can contribute $3,000 to a traditional IRA and $2,000 in a Roth IRA.
IRAs are available from banks, credit unions, and brokerages. Visit our investing section for tips on what to put in your retirement portfolio.
Sign Up for the Company 401(k) Plan
In the U.S., many companies offer an employer-sponsored retirement plan called a 401(k) plan (similar plans may have other names when offered by different types of organizations). These retirement plans are usually offered once employees have been with the company for a specified period of time.
A 401(k) plan offers tax-advantages similar to a traditional IRA — contributions are tax-deductible. The biggest perk available through a 401(k) plan is the employer contribution match, which may vary from company to company (some companies don’t offer a match).
For example, if your employer offers a dollar-for-dollar match up to 5% of your $40,000 salary, your company will contribute $2,000 when you contribute $2,000, for a total of $4,000. (Your contribution of $3,000 will still result in a $2,000 employer match.)
Basically, it is free money. Can you say “no” to that? Unfortunately, many people do.
Again, like IRAs, if you missed a 401(k) contribution in any particular year, you miss the tax advantages and the employer match, if any.
A possible drawback to 401(k) plans is the limited pool of investments. With IRAs, you can choose the brokerage based on the types of investments that you can choose from and the costs of trading these investments. In the case of 401(k) plans, your employer chooses the provider.
Sometimes, the investment choices are small and/or come with high annual expenses. This is the reason why many people contribute enough to maximize the employer match and then focus on contributions into their IRAs. Once they max out their IRAs, they can contribute more to their 401(k)’s if they want to.
Speak to the human resource department about your company’s 401(k) plan and ask when you will become eligible. You may be able to set up monthly contributions, so they’re automatically deducting a portion of your paycheck.
(Note: there are Roth 401(k) plans too.)
Simon Zhen is a research analyst for MyBankTracker. He is an expert on consumer banking products, bank innovations, and financial technology.
Simon has contributed and/or been quoted in major publications and outlets including Consumer Reports, American Banker, Yahoo Finance, U.S. News – World Report, The Huffington Post, Business Insider, Lifehacker, and AOL.com.